Monday, December 15, 2008

If you are like me you have probably been asking yourself who would buy T-Bills with a 0% yield; it just does not make sense. The popular answer is "Treasuries are experiencing a flight to safety," but who is the pilot? The US Treasury released Treasury International Capital (TIC) data on Monday. The TIC data showed a disturbing trend for holders of long term US Treasury securities, while also explaining why short term Treasuries have been doing so well.

In October, foreigners sold $34 billion of long term treasury securities, while purchasing $92 billion of short term treasuries. The treasury has kept tabs on foreign purchases of US debt since 1978 and the amount of long term securities sold in October 2008 was second only to August of 2007 when foreigners sold $37 billion. But, foreigners bought short term securities so all is well, right?

It is no secret that foreign buyers of Treasury securities have been one reason the US has been able to sustain a large debt load. In fact, foreign buyers have kept up pace with the rate of change of debt issuance.

Even with the unprecedented run-up in outstanding US debt, foreign investors have not lost their appetite for T-bills, notes, and bonds. The chart illustrates the rate at which foreigners have bought new debt has outpaced the rate at which the US Treasury has issued debt. However, the gap appears to be narrowing and this could be cause for concern.

Despite the recent frenzied buying of short term securities, the percentage of US debt owned by foreigners has been declining since the start of the credit crisis in July 2007.

On aggregate, foreigners have been buying fewer Treasury securities as a percentage of all marketable debt outstanding. If the US plans on increasing its debt load then foreign investors must reverse this trend. The continued divergence of these two lines means only one thing: higher interest rates. Probably the easiest way to think of this chart is supply (outstanding debt) vs demand ( foreign ownership of debt). Econ 101 tells us that if demand falls and supply increases, then price decreases. In terms of US debt, lower prices mean higher interest rates. If another buyer steps into the market then higher interest rates are not inevitable.

In October, as part of the Emergency Economic Stabilization Act, the Congress approved a debt limit increase to $11.3 trillion. Currently the national debt stands at $10.6 trillion. If the US maxes out its credit line (a highly likely scenario) that would translate into a 7% increase in debt outstanding. Since foreigners are not the only buyers of US debt, someone will have to fill that gap, especially if the decline in foreign ownership continues. The trillion dollar question is, will the new buyer agree to the same 0% terms that the current buyers are receiving?

Sunday, December 7, 2008

As the snow fell this weekend, my thoughts wandered to the balmy days of late June 2008. Oil prices were screaming higher and the US Congress took notice. In a series of painful hearings, oil executives were grilled about record profits and oil speculators were taken to the woodshed. Unfortunately, the speculators were not represented and could not defend themselves. This was fine with the Congress, since speculators were probably too busy manipulating oil prices to record highs. The Congress referenced the commitment of traders report (COT) as evidence that oil speculators were at work driving up oil prices; they showed charts that illustrated that as long positions increased, oil moved up almost 65%.

Indeed, looking at the COT data for 2008 it is easy to see that speculators increased their long positions ahead of the price spike in July. This was enough evidence for the Congress and even John McCain to publicly indict speculators without giving them the ability to defend themselves.

From October to November 2008, speculators once again increased their positions, except this time they were net short. During this time crude oil prices on the NYMEX decreased from $109 to below $50, over a 50% decline. The decline in oil prices may be the only bright spot in the current economic climate.

This leads me to my original question, where are the Congressional hearings thanking speculators for driving oil prices down?

Thursday, December 4, 2008

I spent the last two days at the Commodity Investment World Conference in New York. The general theme and tone of the conference was that the world has changed dramatically and unprecedented market "anomalies" were occurring. In fact most of the presentations were compiled three weeks ago and were grossly out of date, so most presenters went off the cuff. A simple look at the Dow Jones AIG commodity index illustrates the massive dislocations in the market.

The index peaked in July of 2008 and has since fallen 53%- the largest move in the shortest amount of time since the index began. If you have not looked at the news in 6 months this chart is a surprise, however, even a casual glance at the front page of any newspaper tells you the financial world is in turmoil. Deleveraging resulted in unprecedented correlations occurring between all asset classes, while institutional investors were making irrational decisions to pull money out of well performing funds.

As the conference got through the "Chicken Little" stage there was some blue sky. Thierry Wizman of Fortis spoke about hedge fund withdrawals coming to an end. I asked him for some detail and he told me that the numbers he has seen suggest that hedge funds have raised upwards of 80% of the cash they will need for year end redemptions . This follows the anecdotal evidence that I have gathered from friends and colleagues at large funds. Almost all have gone to cash and are waiting for the new year before they start to re-invest. In fact, many have told me that after this week they are done for the year.

I also chatted with one of the conference organizers and asked him how conference attendance has been overall. He told me that they had seen a surge in interest over the last few weeks as institutional investors were looking for opportunities for the new year.

Supply Shocks

The second general theme was that sometime in the next 6 months to 2 years there will be a substantial supply shock in many commodities, especially oil. The credit crunch has caused rigs to shut down, infrastructure improvements to stop and high cost supply to be unprofitable. The two examples examined were the tar sands of Canada and crack spreads.

In western Canada, the cost to pull a barrel of oil out the tar sands is roughly $70, the highest of all production methods. This does not include deep water Brazil which has yet to begin. In this environment, any company that is perceived to have exposure to oil is being punished and cut backs will lead to supply shortages.

Further, the refiners are losing money from negative gas crack spreads. The gas crack spread is a measure of how much money per barrel a refiner makes by "cracking"oil and producing gasoline.

Currently the gas crack spread is negative and has been that way since the end of October. Obviously refiners will not be able to stay in business for too long if they continue to lose money on the products they produce. This unsustainable trend will likely cause refiners to shut down production and lead to a supply shock.

All in, the take away from the conference was that while the world has changed rapidly, ultimately it will begin to normalize. Eventually, the unsustainable trends will be recognized by market participants and fundamentals will once again become relevant. However, as long as the credit crunch continues look for the insanity to continue.

Tuesday, December 2, 2008

The states are in trouble and the water is beginning to flow over the dam. Yesterday, the Governator - Arnold Schwarzenegger, declared a fiscal emergency in California claiming that the state could run out of money by February. As well, the National Conference of State Legislatures (NCSL) and National Governors Association (NGA) released a letter pleading for the Congress to pass a stimulus package. The NCSL reported that 30 states have shortfalls totaling $30 billion, while California already has a budget gap of $11 billion. Interestingly, municipal bond yields have not responded to these developments and that represents a juicy opportunity for investors.

Currently, 30 year Aaa bonds are yielding 5.6%%, while 30 year Baa bonds are yielding above 9%. In contrast, 30 year Aaa municipal bonds are yielding 5.3%. An historical look at Aaa and Baa corporate bonds reveals that the yields are near all time highs.

Furthermore, GE was re-affirmed as a Aaa credit rating today even though it announced weaker than expected earnings. The key of course is the earnings part, they still have some. However, California and 30 other states have an "earnings" shortfall.

If we look at the municipal bond yield curve for Aaa general obligation bonds, it is clear that the yields have not changed dramatically over the last six months, while economic conditions have deteriorated. In fact, the unemployment rate for the US as a whole is at the highest level in over 8 years.

Two of the most populous states and economically important are California and New York. Over the last year the unemployment rate in California has risen to all time highs. It is not difficult to deduce that the higher unemployment rate means people spend less and fewer taxes are collected. Throw in a legislative reluctance to raise taxes and voila, an economic crisis.

Great charts, but how do we make money from this?

The simple answer is to short municipal bonds and the easiest way to do that is to sell short the iShares National Municipal Bond ETF (MUB). This etf invests in primarily Aaa rated municipal bonds and over 30% of the portfolio is concentrated in issues from California and New York.

While investors have been running into the US government bond market they have ignored the municipal bond market and its inherent weakness. Once the market realizes that these Aaa rated muni bonds are less safe than both Aaa and Baa corporate bonds then the yield should increase while price decreases to reflect the new risk premium.

Tuesday, November 25, 2008

The global gold hedge book has seen dramatic changes as a result of gold producers systematically reducing hedges to take advantage of higher prices. Over the last year, gold producers have reduced hedges by over 40%, resulting in the lowest amount of gold hedges since 1987. GFMS and Societe Generale recently released their quarterly report on the hedge book, the following table summarizes the hedge book over the last year.

Composition of the Delta-Adjusted Global Hedge Book

Moz

Q2 07

Q3 07

Q4 07

Q1 08

Q2 08

Q3 08

YoY Change

Q3 07 vs. Q3 08

Forwards & Gold Loans

23.58

20.20

18.26

14.92

13.44

11.92

-40.9%

Options

10.02

8.99

8.60

7.96

5.51

5.00

-44.4%

Total

33.60

29.19

26.86

22.88

18.95

16.92

-42.0%

Source: GFMS

Until recently, the preferred method of hedging was the use of forward contracts since they have a delta of 1 and provide a 1 to 1 hedge on production. However, as the price of gold increased, producers and shareholders were no longer satisfied with limited profits. Naturally, they wanted to take advantage of any upside in price, while also protecting against the downside. To accomplish this goal producers are now hedging downside risks with put options.

The reduction in forward contract hedging and the trend toward purchasing put options has radically changed the composition and sensitivity of the hedge book. As recently as the first quarter 2008 the hedge book was structured in such a way that in a rising price environment market makers would have to sell more gold to hedge their positions. When gold prices fell, market makers would have to buy more gold. As market makers adjusted their position they kept volatility low by selling into rallies and buying dips.

The following tables are based on data from GFMS and compiled by Societe Generale in the report "Global Hedge Book Analysis." These tables illustrate the changes in delta-adjusted volume during periods of different gold prices and volatility.

Sensitivity of Q1 08 Options Book as of March 31, 2008

Move in Volatility (%)

Move in Gold Price (US$/oz)

-200

-100

0

100

200

4

7.59

7.78

7.96

8.07

8.12

3

7.59

7.79

7.96

8.07

8.13

2

7.59

7.79

7.97

8.08

8.13

1

7.60

7.79

7.98

8.09

8.14

0

7.60

7.79

7.98

8.09

8.15

-1

7.60

7.79

7.99

8.10

8.15

-2

7.60

7.80

8.00

8.11

8.16

-3

7.60

7.80

8.01

8.12

8.16

-4

7.60

7.80

8.01

8.12

8.16

Source:GFMS

The simplest explanation of the table is that the larger the numbers the more gold needs to be hedged. This hedging is undertaken by the banks and brokers (market makers) that are writing options to the gold mining companies.

For example, if a mining company purchases a put option the writer of that option will in effect be long gold. In gold hedge book terms this is called being long delta volume. Suppose the delta of the option written is +0.5 and the nominal value of the trade is 100,000 ounces, then the writer of the option (market maker) is exposed to being long 50,000 ounces of gold. Typically the market maker does not want to make a directional bet so they must offset the risk. The market maker will borrow 50,000 ounces of gold from a central bank and then sell that gold in the spot market, effectively eliminating directional risk. In this way, the hedging activities of the mining companies are reflected in the spot price of gold. This is why the sensitivity of the options hedge book is so important to gold prices.

For most of the current decade the delta-adjusted volume has increased as gold prices increased and decreased when the price of gold fell. This was primarily because the hedging activities were concentrated in forward contracts with a delta of 1 and resulted in a 1 to 1 offsetting trade. The following table illustrates the change that occurred in Q2 2008.

Sensitivity of Q2 2008 Options Book as of June 30, 2008

Move in Volatility (%)

Move in Gold Price (US$/oz)

-200

-100

0

100

200

4

5.80

5.61

5.50

5.45

5.43

3

5.80

5.61

5.50

5.45

5.42

2

5.80

5.60

5.49

5.44

5.42

1

5.80

5.60

5.49

5.44

5.42

0

5.80

5.59

5.48

5.43

5.41

-1

5.80

5.59

5.47

5.43

5.41

-2

5.81

5.58

5.47

5.42

5.41

-3

5.81

5.57

5.46

5.42

5.41

-4

5.81

5.56

5.45

5.42

5.41

Source:GFMS

There are two striking observations about this table. First, the absolute amount of delta-adjusted volume has decreased, which makes sense in an environment of de-hedging activity. Second, and most importantly, the sensitivity has reversed. Now, as gold prices rise market makers will have to buy gold to offset directional exposure, while in a falling price environment market makers will have to sell gold.

The net outcome is that volatility has increased as market makers have essentially become momentum players buying and selling with the prevailing trend. Looking at the log change in prices of the SPDR Gold Trust (GLD) provides a standardized comparison of volatility.

It is clear that in the last 3 months the changes in the price of GLD have become more volatile and the volatility followed both up and down markets.

Sensitivity of Q3 2008 Options Book as of September 30, 2008

Move in Volatility (%)

Move in Gold Price (US$/oz)

-400

-100

0

100

400

4

5.62

5.08

5.01

4.97

4.96

3

5.64

5.08

5.01

4.97

4.96

2

5.65

5.08

5.00

4.97

4.96

1

5.66

5.08

5.00

4.97

4.96

0

5.67

5.08

5.00

4.97

4.96

-1

5.68

5.07

5.00

4.97

4.96

-2

5.70

5.07

5.00

4.97

4.96

-3

5.71

5.07

4.99

4.96

4.97

-4

5.73

5.07

4.99

4.96

4.97

Source:GFMS

The most salient observations about this table is that once again the amount of hedging has decreased and the sensitivity of the book has decreased remarkably. In June 2008, a $100 decrease in the price of gold would result in the amount of gold sold as a result of offsetting hedges to increase by 0.11 million ounces. Now, a $100 decrease in the price of gold results in 0nly 0.08 million ounce increase in the amount of offsetting gold hedges. The prevalence of put options has had a large effect on the the price of gold.

The result of all these changes is that if the price of gold begins to trend up it no longer has the twin headwinds of the mining company hedgers and the market maker hedging activities. In fact, gold has an implicit tailwind built into the structure of the market.

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About Perception is Reality

Perception is Reality rejects the central tenet of the efficient market hypothesis that the markets reflect all known and unknown information.

Reality or "truth" in the financial markets has an ever changing definition. The chaotic nature of new information renders it unknowable, and therefore market participants can only act on their perception of information. When enough investors perceive information in the same way it can often lead to that perception becoming reality.

The financial markets are the manifestation of the push and pull between reality and perception. Therefore, successful investing must start with market perception.

Perception is Reality is updated with insight on the prevailing perception in the global financial markets.

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About Brian Kelly

Brian Kelly is Founder and CEO of Kanundrum Inc. a private investment company and research boutique. He has 13 years experience in trading and investing.

He received his BS in Finance from the University of Vermont, while also being able "squeeze-in" at least 3 days of skiing per week. After a year in the real world, making cold calls as a retail stockbroker, he decided to retreat to the safety of academia and received his MBA from Babson Graduate School of Business.

Then back to the real world again, where he spent the next 10 years trading equities for pension funds, mutual funds and hedge funds. He specialized in risk arbitrage, pairs trading and relative value strategies.

While in the real world he founded a brokerage firm that catered to the institutional equity trading community.

And finally he is the founder and CEO of Kanundrum Inc. (www.kanundrum.com), a private investment firm and research boutique.

What the future holds is unknowable, but hopefully he will still be able to "squeeze-in" some time on the slopes.

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Our overriding investment philosophy is that reality in the global financial markets has an ever changing definition. The goal of our research is to find situations where market perception has diverged significantly from reality. Our reports combine fundamental research, market structure and the impact of investor behavior.